The underlying issue is China's credit fueled expansion and
that any moves to impose discipline lead to a run up in money
market rates and risk provoking a crisis.

The roots of the run up in rates this time around are the
same as those that precipitated the credit crunch in
June.

The reserve requirement ratio, or the cash reserves that the
Chinese central bank mandates banks need, has become a real
constraint for banks. And
the shadow banking system makes it more complex, because it
allows banks to overextend themselves but these liabilities
don't show up on balance sheets.

We should expect more instances of rising money market rates
going forward. But it isn't limited to this. We've seen
government and corporate bond yields go up in the past several
months. So this isn't a fluke regarding the interbank lending
market.

The interbank lending market is "a petri dish of risk," and
China's financial system has become fragile and tangled up.

The investment led growth model has made it so it's almost
like the PBoC has ceded control of monetary policy to the shadow
banks.

The People's Bank of China is faced with a difficult choice,
accommodate the banks or risk them going bust.

The rise in Chinese money market rates, not the Fed taper, is
the biggest financial story of the holiday season.

Patrick Chovanec: Well I think the underlying
issue here is that China has been increasingly dependent on
rampant credit expansion to finance its investment boom, and also
to paper over losses from investments that have gone bad. And
what that means is that more and more credit is needed to
generate less and less real output. The People's Bank of China
(PBoC) is very aware, and has been aware for many years of the
danger of rapid credit expansion and that both it's fueling
rising bad debt and also causing inflation, particularly asset
inflation in the property market in China. But when they try and
dial it back even a little bit, not tighten, just try to rein in
the rate of credit expansion, they find that you've got banks and
investment vehicles and companies that are overextended and can't
meet their obligations.

That means that they either they have to pull the rug out from
under them or essentially accede to their need for cash.

There's some people saying this is the PBoC, the Chinese
government, trying to take control of the banking system. And in
a sense it is but they are playing catch up and every time they
do try they try, to use the word clamp down overstates it, that's
the problem, every time they try to impose any kind of discipline
over the rate of credit expansion, they risk provoking a crisis.
So they end up accommodating the rampant credit creation that's
already taking place. They're presented with a fait accompli -
we've lost all this money or we have to roll over these debts,
accommodate us or else.

BI: Some are saying this is like the credit crunch we saw
in June...

PC: The roots of it are the same, maybe not the
immediate causes, you can point to different immediate causes of
why you know at the end of the year there's a particular need for
cash. You have a couple of things going, the first is that for
two years now, we've had at the end of every quarter there's a
spike in the interbank lending rate, used to go up to 5%, which
is now nothing, it used to go from 2-5%. What would happen was,
small banks throughout China would blend, and they would turn
then to the larger banks, and that's the way the interbank
lending market has worked in China traditionally. It's the large
banks are the ones that are basically the recipient for deposits,
and the small banks throughout China are the ones that spearhead
lending. And so it's the opposite of the way it used to be in the
United States, with the money center banks, where basically you
had all the smaller banks in the country that were taking in
deposits and then they would send the money to New York to the
interbank lending system, and those banks would be the main
lending banks. It's the opposite of that. And the reason it is
the opposite is that a lot of China's deposit growth is driven by
its current account surplus, and to some degree what used to be a
capital account surplus. And the large banks were the recipients
of those deposits.

What happened was that every quarter, to meet the reserve
requirement ratio, so every quarter the reserve requirement ratio
became a real constraint in the beginning of 2011. We saw every
quarter it would spike. They would make the loans and say we have
to cover our positions. We have to get the cash to meet reserve
requirement and that would place pressure. What subsequently
happened, on top of that, that continues to be the case, but it's
become more complex. The shadow banking system has both allowed
banks to overextend themselves even further, in the hope that
they can bring a bunch of stuff on the balance sheet at the end
of the quarter. And the other thing that happened is there are a
lot of instruments roll over at the end of every quarter and they
are supposedly just investment instruments and have nothing to do
with the banks' balance sheets. They're not on the banks' balance
sheets. The money to cash them out is supposed to come from
the investments themselves but they're not generating cash
they're completely illiquid investments and so when they roll
over the banks can just let them default, which they don't want
to do. Not only do the have unhappy customers, they would have to
default. So, what they end up doing, is they cash them out
themselves and what that means is that there is a cash obligation
that banks have, that shows up nowhere on their balance sheets.

That's why I use the word shadow bank, because it's not just
informal lending as it used to be, but it has really become a
hidden balance sheet to the banks, and that balance sheet has
both assets of questionable worth and cash liabilities and
obligations that don't show up. If you look at their balance
sheet you would never say this bank is illiquid. But when people
show up and they want to cash out their products that they bought
and the bank doesn't want to let them default, they need cash.

It's not that the PBoC is unaware of it, but it's very difficult
to gauge because it's not transparent. And also the PBoC has been
trying for the past year or so to discipline the banks, to
prevent them from going out and incurring these sorts of
obligations, but once the obligations are created, they are
there. And the PBoC is sort of presented with a fait accompli,
'okay you told us not to, but we did, and if you don't give us
the cash to cover this then we're bust' and they [PBoC] say 'well
okay, but don't do it again'.

BI: So, going forward, should we expect more of these
rate spikes?

PC: Yeah. Back in June I said we're going to see
this again, this is not an isolated incident. People said this is
an isolated incident, some kind of aberration, the PBoC did it
internationally to show people who is boss. Maybe yes there is an
element of them imposing some kind of discipline but when they
try they get this hug result which they didn't expect and this is
a chronic problem. I think I may even have said this to you, that
China's financial system has high blood pressure. In June it had
a heart attack, it wasn't fatal but the heart disease is still
there.

And it's not just the interbank lending market by the way.
Everyone focuses on the interbank lending market but we've seen
yields go up across the board in China. We've seen government
bonds, we've seen corporate bonds, the rates go up steadily
throughout the past several months. So this is not something
that's sort of a fluke regarding the interbank lending market.
Although the interbank lending market is a petri dish of risk.
There are so many cross currents, there's so much circular money
flows that goes through the interbank lending market to keep
everyone liquid that's why it's the most complicated, the most
fragile, and the most vulnerable to these sort of spikes.

BI: So where does this leave the PBoC which on the one
hand is going for reform but on the other is still injecting cash
to alleviate the symptoms?

PC: This is where it's bigger than the PBoC and
it's management of monetary policy. This is where after the Third
Plenum and the big report that was issued, everyone was so
excited about it and I said wait a minute, because the biggest
problem that they have is the fragility of the banking system.
That they are on a runaway credit train and they have to rein it
in, but the moment they try and rein it in they get which was
always a reason why they shied away from it in the past, but also
defaults. And that's where de-regulation of interest rates and
accountability they look great on paper, but when you try and put
it to practice then the imbalances have become so great, that
there's a real cost to be paid. And this reminds me of back in
April after they had a lending boom and GDP nevertheless
slid, instead of producing a bump, it slid, Premier Li and he
said we can no longer use credit fueled investment stimulus to
drive growth, we have to engage in real reform, real rebalancing,
shift to a new growth model and it's back to a month before when
he stood before the MPC and said reform is going to be painful
like slitting our wrists. So, I think there was this
recognition on his part that this was a dead end, that yes you
could kick the can down the road, but this road was a dead end.
And that moving away from it would be very painful.

But look what happened in May going into June, you had a
government bond issue fail and then you had the June credit
crunch. Again, the moment you try to dial it back, even a little
bit, you get something where they say okay, we capitulate, we
have to provide whatever cash is necessary to keep everybody
liquid. And again what you effectively do is cede control of
monetary policy to the shadow banks, not in the sense that this
is some kind of agenda they have. It's just the model that pushes
out investment led growth through insatiable demand for credit
but is generating less and less real result. The question is how
do they get over it? When you're in a hole the first you do is
stop digging.

BI: The PBoC's open market operations don't even seem to
be helping...

PC: It's hard to tell what the PBoC is doing
right now. And it was hard to tell in the after math when they
move from their transparent mechanism like reverse repos, but
what we saw in June was to directly providing assistance without
any announcements, to key banks. I've heard there were TARP like
sums involved in order to ensure liquidity. We don't know, they
might announce they're doing something but we wont know the
amount, the conditions, or the recipients. They can certainly do
that and we may not even be fully aware of the level of
intervention. That's why it was a little difficult to interpret
what was happening in the wake of the June liquidity crunch. It
sounds like with these SLOs they're moving in that direction of
direct under the table assistance to key banks, on an undisclosed
basis. We'll see it with rates falling they'll do whatever they
have to do to bring the rates down. But it doesn't solve the
problem, it alleviates the symptoms of the problems. But it
actually makes the problem worse.

BI: There was an
FT report about propaganda officials telling financial
journalists to tone down the coverage of the rise in money market
rates and the liquidity squeeze we're seeing...

PC: It was reported by the Financial Times and
the only thing I know about that is what I read in the article.
But I do think that that is significant. If this really was
something that was not a concern I think they would brush it
aside and they would say talk all you want about it,but we've got
it under control. I always think that whenever they say okay
don't talk about this, it's obviously something worth talking
about. When they protest too much, and it's obviously something.
It just seems to me it shows their anxiety over a situation that
is not easily containable.

It is easily resolvable in that the PBoC can print as much money
as it wants, and yes you can bring rates down and you can have
plentiful liquidity in the system. But then what have you done?
You've basically waved the white flag, you've said okay we're not
going to rein in credit at all, in fact we're going to give you
as big of a punch bowl as you could possibly want. They could
that but that would only make it worse because the lending
continues, the bad debt continues to rise, you have to roll over
even more bad debt, and the demand for cash becomes even greater.
And in the mean time you're pumping all this money in, and its
going into the property market and bidding up property prices
like crazy.

BI: What is the biggest takeaway from this for
investors?

PC: The biggest takeaway, when I was writing on
the risk of financial instability in China two years ago, most
people would laugh like that's ridiculous. And I think it's
starting to dawn on people just how fragile, and what's the word
I'm looking for, tangled China's financial system has become. A
lot of people say they hold $3.5 trillion in reserves, they own
the banks, which is all true, though the bit about the $3.5
trillion in reserves is irrelevant. But people would say stuff
like it's inconceivable that we would see any form of financial
instability in China. Well what we're seeing is a form of
financial instability. It takes place in the context of a week
ago when a major trust blowing up. So it's not some kind of
isolated thing, we see yields rising across the board, we've seen
a major trust product blow up, the latest of many that did not
garner the same attention. Credit risk is rising, you talk to
most Chinese officials, they'll admit credit risk is rising. And
we see overall debt levels rise dramatically in China. And we've
got the interbank lending market, which is keeping everyone from
defaulting, is on the verge of a breakdown. Because once you get
above 10% the market begins to break down.

BI: How would you describe China's financial system in
one sentence?

PC: I don't think people have appreciated how
much China's financial system has changed in the last three
years. It is unrecognizable from what it was. I'm not going to be
flip and say it's a Ponzi scheme, but the risk of real financial
instability China has been neglected by people for a long time.

BI: Is there anything else you think our readers should
know?

PC: One thing I would add is we think of China
as an emerging market, that's going to go through it's own
emerging market crisis and it's not going to affect the rest of
the world. But it's the number two economy in the world. The
global financial system doesn't have that much direct exposure,
but there's a lot of indirect impact through China's real
economy, through currency flows, capital flows in particular,
we've see the U.S. dollar carry trade over the past several
months. I would say what's going on in China right now is the
most important story over this holiday season. It's the most
important financial story out there now. I mean honestly compared
to QE, they reined in QE purchases by $10 billion a month,
big deal, compared to the idea that you could have the financial
system in the second largest economy in the world really go
haywire.